Americans for Financial Reform (AFR) hosted a conference call with reporters and bloggers on Thursday, September 1, 2011 to discuss problems in the oversight of the major credit rating agencies and ways to achieve better ratings agency accountability under the Dodd Frank Act.

The Financial Crisis Inquiry Commission concluded that major credit rating agencies such as Moodys and S&P were “essential cogs in the wheel of financial destruction”. The financial incentives ratings agencies face to inflate their ratings led to a breakdown of agency integrity before the financial crisis, with disastrous results. From 2000 to 2007 the ratings agencies gave their highest AAA ratings to tens of thousands of mortgage backed securities – the same securities that triggered the disastrous 2008 crash. Research has found that less than 2 percent of these securities actually satisfied the agencies’ stated standards for AAA credit.

Excerpts from remarks by panelists:

Senator Al Franken, hehas been a leader in the fight for rating agency reform. His amendment to the Dodd-Frank Act (Section 939F) requires the study and possible implementation of fundamental changes to the rating agency business model.

“Today we are taking about an industry that is fundamentally flawed. In the credit ratings agency industry issuers pay the ratings agencies to rate their products, so it should come as no surprise the system tends to produce very high ratings for products that shouldn’t be. When a rating agency doesn’t give the issuer the AAA rating that they are seeking, the issuer can go elsewhere with their next product. Defensively the ratings agencies tend to give AAA ratings and of course, that is what we saw to the lead up to the financial meltdown. Fitch, Moody’s and Standard & Poor’s gave AAA ratings to subprime mortgage securities and when the banks ran out of those mortgage backed securities they gave AAA ratings to the derivatives – the bets on the bets and then the bets on the bets on those bets. This created a house of cards that would have existed if the credit ratings agencies hadn’t had this perverse conflict of interest, which is give a high ratings to someone that doesn’t deserve it. As a result, we had the meltdown and this was a huge part of the meltdown. And is the reason for this oligopoly that we see with Moody’s, Standard & Poor’s, and Fitch – and this conflict plagued system still persists. The oligopoly still persists and the dangers still persist. The Senate Permanent Committee on Investigations got all kinds of emails from within the credit ratings agencies that just back all of this up.

The problem, as I see it, is that the recent rule proposed by the SEC doesn’t resolve the conflict of interest that is inherent in the system that exists, which is caused by ‘ratings shopping.’ Fortunately the SEC still has the opportunity to tackle this conflict problem.

During the debate on Dodd-Frank with help from AFR, I secured the passage of an amendment, this is a bi-partisan vote – Roger Wicker of Mississippi was my chief co-sponsor and he’s a conservative as you get. This is not a progressive idea or conservative idea — it’s a common-sense idea.

What the amendment did was create an independent board to assign ratings agencies to provide the initial ratings on products. This assignment process would prevent issuers from negotiating higher ratings from the ratings agencies. It would also take away the issuers primary leverage away – threatening to take their business elsewhere. Over time the board could take into account the performance of the ratings agencies that specialize in different sectors. These ratings agencies would be chosen by the board which would be comprised primarily from people in the investment community, people that manage pension funds, institutional investors, credit ratings agencies, and banks as well. This would mean new credit ratings agencies that are smaller and developed expertise and through time these agencies could be selected through their record for accuracy. Instead of pay to play, we’d switch to pay for performance.

This new system would increase competition in the industry, smaller players would have a chance to compete based on their accuracy and performance and develop niches – these ratings agencies would be assigned on basis of expertise and capacity. My proposal would restore integrity to the credit ratings industry and create a market that rewards accuracy and promotes competition.

My proposal was during the conference process between the House and the Senate – it was downgraded to a study, but it was a study with enough allies that after the study is completed, and if the conflict of interest still persists, and it does, and has not been addressed, my amendment shall be implemented. The SEC is soliciting comments on my proposal through September 13th and my hope is the review of submitted comments would produce recommendation to implement my proposal.”

Barbara Roper, director of Investor Protection for the Consumer Federation of America and a longtime advocate of ratings agency reform.

“We warned at the time the legislation was adopted that whether Dodd-Frank delivered the fundamental changes promised by Congress and demanded by the severity of the problem would depend in large part on regulators’ willingness and ability to adopt tough implementing regulations. Indeed, because the legislation failed to tackle the conflict-of-interest issue comprehensively, getting the implementing regulations right is of supreme importance. Unfortunately, the news on that front so far is not encouraging.

Regulators have struggled to implement the requirement to eliminate all regulatory reliance on ratings. The SEC has been forging ahead with this task. But, with the notable exception of their proposed rules for asset-backed securities (which have yet to take effect), most of their proposals have failed to impose any alternative measures of creditworthiness to substitute for ratings. On enhanced transparency, the news is better. The proposed rules issued by the SEC should significantly improve the quality of information users of ratings get, both about the past performance of the ratings agencies and about the assumptions underlying the ratings and their sensitivity to those assumptions. But in the crucial areas of enhanced regulatory oversight and reduced conflicts of interest, that same set of rule proposals represents a huge missed opportunity. In the area of regulatory oversight, for example, the proposal would not impose any standards governing the control procedures ratings agencies have to put in place to ensure compliance with their own policies, procedures and methodologies. Whatever the ratings agencies come up with is fine. Past experience tells us that the result will be controls that are both inadequate and unenforceable.

And, with respect to conflict of interests – where the law actually gives the SEC very broad authority – the Commission has proposed simply to require the rating agencies to do what they already claim to be doing – maintain a strict firewall between the sales and marketing staff and the analysts. This ignores the truly voluminous evidence – from the Commission’s own study and from the study by the Senate Permanent Subcommittee on Oversight and Investigations – that it is upper management, not low-level marketing staff, who are the primary source of the problem on conflicts of interest. Any rules that don’t recognize that basic fact are bound to be useless in restraining those conflicts.

That raises another question: if the SEC is not willing to use its sweeping authority to address conflicts of interest in one area, what hope do we have that they will implement the Franken amendment in a way that provides meaningful new protections against conflicts?”

Eric Kolchinsky, former Managing Director of the Moody’s business line responsible for rating collateralized debt obligations backed by subprime mortgages and 8 year veteran of Moody’s corporation and was formerly employed by Goldman Sachs, Merrill Lynch, Lehman Brothers, and MBIA.

“I am also concerned that there have been no significant changes, since the financial crisis, in the way that rating agencies operate. The current market for rating services is not materially different from the legacy system which led to poor rating quality. Fundamentally, the market for rating services in structured finance involves 1) issuers selecting and paying for 2) a private rating agency to evaluate securities for the public good and 3) based on that agency’s unique set of criteria. The double-flexibility afforded to issuers in selecting the rating agency and to the rating agency in selecting the criteria effectively implies that issuers are selecting the criteria that they will be evaluated under. This dynamic is called ‘ratings shopping’.

Today, there is little change in the market for ratings. The implementation of Dodd-Frank does not fundamentally change any dynamics in the financial markets or align incentives of any party. Specifically, the proposed rules focus on the potential “rogue” employee and not the poorly incentivized management which, I believe, were responsible for the poor rating quality. The rules also rely on the very same management to police itself and leave in place the dynamic which allows issuers to “rating shop” for their preferred methodologies.”

“The Dodd-Frank Act cracked down on the credit rating agencies, the firms that awarded rosy ratings to bonds backed by junky mortgages, but some lawmakers and consumer advocates contend that the regulatory overhaul falls short. … ‘This is not a progressive or conservative idea — it’s a common-sense idea,’ Mr. Franken said on a conference call with reporters, hosted by Americans for Financial Reform, a consumer advocacy group. ‘Instead of pay-to-play, we’d switch to pay-for-performance.’ … Barbara Roper, director of investor protection for the Consumer Federation of America, likened the rules to the ‘Chinese restaurant approach to reform,’ offering a smattering of options but no comprehensive overhaul. ‘The commission has proposed simply to do,’ she said on the conference call, what the rating agencies “already claim to be doing.” Click here for more.

“Two of the biggest advocates of credit ratings agency reform warned Thursday that the credit rating agency reform proposals put forth by the Securities and Exchange Commission as part of Dodd-Frank are inadequate, and that the ratings agencies are returning to practices that helped spur the financial meltdown. The pair—Sen. Al Franken, D-Minn., and Barbara Roper, director of investor protection at the Consumer Federation of America—spoke during a conference call held by Americans for Financial Reform.” Click here for more.

“If it’s broke, fix it. That’s what critics of the nation’s credit rating agency system believe, contending that it’s in sore need of overhaul to prevent a repeat of the financial meltdown of 2008. Sen. Al Franken (D-Minn.) exhorted the Securities and Exchange Commission to provide a major makeover to the nation’s credit agency system that he called ‘fundamentally flawed.’ Franken was one of three panelists who participated in a conference call on Thursday sponsored by Americans for Financial Reform. Click here for more.